Are Israel's Start-ups Poised to Suffer the Same Financing Gap as Their California Peers?

Just like in Silicon Valley, the vibrant entrepreneurial scene in Israel is also driven by the desire to get companies off the ground quickly and cheaply and sell them, preferably for top price.

Two talented go-getters, a good idea, and a $60,000 investment were all that was needed to turn Instagram into a billion-dollar company within a year and a half of its launch.

The Instagram dream was the high point of the exuberance sweeping the high-tech world since the dawn of the mobile Internet revolution. The dream of getting rich quick has drawn countless entrepreneurs from all corners of the world and plenty of money from small investors, angels, former entrepreneurs and many others. The result has been a flood of companies established hoping to duplicate the success.

Just like in Silicon Valley, the vibrant entrepreneurial scene in Israel is also driven by the desire to get companies off the ground quickly and cheaply and sell them, preferably for top price.

“When people read about exits or a techie who struck it rich, it stimulates their appetite for taking chances,” explains Koby Simana, CEO of IVC Research Center.

He cites Intucell and XtremiO. The two Israeli startups, one in data storage and the other in communications, were sold in the past year for a pile of money: following a relatively small investment − $6 million in Intucell’s case, or before completing the development stage and moving on to sales and marketing in the case of XtremiO.

In light of the easy money and high valuations received by young startups, many are contending that a new dot-com bubble is developing and have voiced concern that the whole thing will blow up.

One prime example is the rise and fall of Color Labs, a U.S. startup. In 2011 the company raised $41 million from leading investors like Sequoia Capital even before launching its product, a smart phone social application with photo sharing, targeting the hottest trends at that time. Later the same year it was revealed that Color Labs turned down a $200 million check from Google. The application ultimately failed to catch on and last October Apple was said to have bought the company for a paltry few million dollars.

The industry hasn’t gone down in flames like in 2001 but in the past year disillusionment has certainly become evident. One of the hottest debates in Silicon Valley in 2012 was over the existence of a Series A crunch: the gap between the number of companies of several hundred thousand dollars starting out in the seed rounds and the number of companies succeeding in the first ‏(Series A‏) rounds of funding from institutional investors − the venture capital funds.

The funding gap is leading to a “Death Valley” for the nascent startups that arose in droves, raised their initial capital from angels or family and friends, but can’t raise enough to reach the next step. Some of the companies that came up with a business plan remain tiny with slim chances for achieving any serious growth and many are simply being shut down.

Natural selection

After a long period of the Series A crunch being discussed mainly on blogs and in opinion columns, new data accumulated in recent months show that the nature of bubbles is to burst − and at least in Silicon Valley a problem has arisen.

Figures published by the research firm PitchBook show that the number of deals at the seed and angel investment stage nearly quadrupled in the past four years, a rate unmatched by the number of first funding rounds. According to PitchBook 3.3, deals at the seed stage are closed today for every first round transaction, compared with a 1.9 ratio in 2008.

CB Insights, another research company, began releasing another series of data in December 2012 underscoring the problem. The company analyzed 4,056 seed investments − most of them less than $1.5 million − in high-tech companies by angels or venture capital funds since the beginning of 2009. The research shows that the level of first-round investment has remained stable while seed investments have exhibited tremendous growth, generating excess demand for the limited supply of investment.

“’Natural selection’ will ultimately be positive, but it means that many startups will become orphaned and some of the investors will lose their money,” according to the research conclusions. CB Insights estimates that more than 1,000 companies will be orphaned, meaning they won’t succeed in raising funds in further rounds. On average, 39% of seed companies succeeded in obtaining an additional round of funding. The average period of time elapsed between a seed round and first round was found to be more than 13 months.

According to CB Insights, the gap between early and continued investments is responsible for over $1 billion in losses. “Seed investments are a risky gamble and the reality is that most return the money,” the company’s report said. “The death of startups and investment losses are part of the process separating the good companies and investors from those that aren’t.”

The dying companies create an interesting market for vultures interested in acquiring talented programmers or acqui-hiring: the buyout of a startup to acquire the entire team rather than the product itself. CB Insights sells a list of 1,000 perishing companies for $4,895.

Winds of change in Israel

Figures for Israel, at least for now, don’t indicate a Series A crunch similar to that in Silicon Valley, but those in the field feel the wind changing direction. “Silicon Valley is experiencing what will be happening in Israel in the next half-year: There’s a lag between them,” says Shuly Galili, co-founder of Upwest Labs, an accelerator program for Israeli companies in the Silicon Valley.

Tal Barnoach, a super-angel, can also see it happening in Israel. “We’re entering a very difficult period,” he says. “If we don’t come to our senses at the level of angels and [VC] funds and there isn’t any discussion on how to solve the problem, we’ll reach a situation where we don’t have any companies that succeed in moving forward. There are many companies that raised seed money and can’t raise anything in the first round. It’s one of the big problems plaguing our industry, and it’s going to get much worse in the next year or two. The resulting vacuum will produce a very difficult problem.”

“You can see a steady rise in the proportion of initial funding rounds, so we’ll see an impact and collapse ahead,” says attorney Lior Aviram, head of the high-tech department at the Shibolet & Co. law firm. “Every phenomenon has a counter-phenomenon. If there isn’t an immediate and proportional increase in money available for high-tech investment it won’t be possible to continue investing, certainly not at rising values.”

Dreamstime
Daniel Bar-On
Ofer Vaknin